The Iraqi Stock Market: Development and Determinants

Juergen Kaehler* and Haider Salahal-Din Aref**

May 2010

* University of Erlangen-Nuremberg and ZEW ** University of Baghdad and University of Erlangen-Nuremberg Address for correspondence: Prof. Juergen Kaehler PhD Institute of Economics University of Erlangen-Nuremberg Kochstr. 4 (17) D-91054 Erlangen Germany Phone: (+49) 9131 852 2083 Fax: (+49) 9131 852 2060 Email: Juergen.Kaehler@wiwi.phil.uni-erlangen.de

1 Introduction
A well-functioning stock market is one of the cornerstones of an efficient market economy. It facilitates the transfer of funds from the savings of investors to the financing requirements of companies. Iraq, with all its recent and current political upheavals, its security and economic problems and reoccurring terrorist attacks is still in a quite unstable situation. To some extent, this is also reflected in the lack of development of the Iraqi Stock Market. Certainly, significant improvements have been made in recent years but it seems that there is still some way to go towards a well-developed stock market both in terms of size and of sophistication. In many nascent stock markets, price volatility is very high and stock prices often have a tendency to follow short-run bubble paths. Liquidity is typically low and, therefore, large orders can move stock prices quite substantially. The Iraq Stock Market Exchange (IRX) began operation only a few years ago in June 2004. Therefore, one would expect to find similar inefficiencies on it as on other nascent stock markets. However, we are not aware of any previous academic research of the market to quantify this expectation. Therefore, our analysis is, to a large extent, exploratory in nature. The aim of this paper is to describe the development of the Iraqi Stock Exchange and to present some preliminary results on the efficiency, or otherwise, of the stock market in Iraq. The paper proceeds by first providing background information on the macroeconomic development in Iraq since the beginning of this century. In section 3, the development of the stock market is explained with statistical data. We explore determinants of the price index of the IRX in section 4 and we draw conclusions from our analysis in the final section.

2 Macroeconomic Background
Before analyzing the Iraqi stock market, it is important to consider the macroeconomic background of the country. Clearly, the military invasion of 2003 and the political instability and security problems since then have had a major impact on the economy. Given the state of turmoil, the quality of official statistics is difficult to judge. This general caveat applies to several data reported in this paper. The real growth rate, measured by the percentage change of GDP, is one such variable that was strongly affected by the political, military and security situations that have prevailed during the last few years. Table 1 reports GDP growth rates from 2000 to 2009. In three of those ten years, GDP decreased, with 2004 showing a staggering decline of 21.8 per cent. Quite surprisingly, GDP increased by 52.3 per cent in both 2003 and 2005.

Table 1: Real Growth and Inflation 2000 - 2009

GDP Real Growth Rate 2000 13.0 2001 15.0 2002 -5.7 2003 52.3 2004 -21.8 2005 52.3 2006 -3.0 2007 2.4 2008 5.9 2009 7.8 Source: indexmundi Inflation Rate (CPI) 135.0 100.0 60.0 70.0 29.3 25.4 33.0 64.8 4.7 6.8

Equally spectacular was the development of inflation in the first decade of this century. Both in 2000 and 2001 there was 3-digit CPI inflation, but from 2002 to 2007 inflation was in the 2-digit range. Although inflation fell to single-digit figures in 2008 and 2009, the average annual inflation in this 10-year period was still as high as 48 per cent. With such a strong cumulative increase of the price level, one would expect at least under PPP a corresponding strong depreciation of the Iraqi dinar (ID). However, as Figure 1 shows, the nominal exchange rate of the Iraqi dinar to the US dollar appreciated from 2004 to 2009 when inflation was still very high. The exchange rate is recorded in price notation from the Iraqi perspective. On 30th June, 2004 there was a strong revaluation of the dinar against the US dollar when the exchange rate was lowered from nearly 3,000 ID per dollar to about 1421 (or from 0.000335 dollars per ID to 0.000704). But even after this massive revaluation, the dinar continued to appreciate against the dollar. At the end of 2009 the exchange rate was only 1134 ID to the dollar. This is very surprising because it implies an extremely strong real appreciation of the dinar. Unless the dinar was grossly undervalued prior to June 2004, this real appreciation should have implied a massive loss of price competitiveness of the Iraqi economy. Apparently, the Central Bank of Iraq (CBI) saw this appreciation of the dinar as a means to fight inflation and to counter the dollarization of Iraq (Al-Salam, 2009).

Fig. 1: Exchange Rate of the Iraqi Dinar to the US Dollar

3,200 2,800 2,400 2,000 1,600 1,200 800 2004 2005 2006 2007 2008 2009

Source: OANDA

An implication of this unusual and unexpected path of the exchange rate is that it is not advisable to convert values in ID into dollar values by the exchange rate for the period from 2004 to 2009. The revaluation of the ID in June 2004 would strongly bias any dollar values. But also the real appreciation of the dinar from 1400 ID/dollar in November 2006 to around 1200 in February 2005 would have a large effect on dollar values. Oil production and the export of oil are of crucial importance for the Iraqi economy. After the military invasion of 2003, oil production quickly recovered but, as illustrated by Figure 2, from 2004 to 2009 there was no clear upwards trend in oil production. Instead oil production seems to be a stationary variable with a quite strong seasonal pattern. In most years, oil production decreased substantially in January. However, the sample period is probably too short to generalize this observation.

Fig 2: Crude Oil Production (millions of barrels/day)

2.6

2.4

2.2

2.0

1.8

1.6 2004 2005 2006 2007 2008 2009

Source: Brookings Institution (2010), p. 28

The overall conclusion about the macroeconomic developments in Iraq since 2004 is, therefore, that despite a clear recovery in many respects the economy is still very volatile. Inflation has come down substantially but the strong nominal and real appreciation of the dinar is puzzling. Clearly, those macroeconomic trends can have repercussion on the development of the stock exchange in Iraq.

3 Development of the Iraq Stock Market

The ISX has a rather short history. It was founded and started trading in June 2004. Before the military invasion of 2003, stock trading took place at the Baghdad Stock Exchange that was founded in 1992. However, the Baghdad Stock Exchange is not considered to be the direct predecessor of the ISX because the Baghdad Stock Exchange was operated by the Ministry of Finance whereas the ISX is a non-profit organization that is owned by its member brokers. Although the ISX started operation June 24th, 2004 there was only one day of trading in that month. Figure 3 displays the number of trading sessions per month from June 2004 to December 2009. It is obvious from this graph that, until quite recently, trading was restricted to only a few working days per week. Some of the variation in trading sessions, of course, is also due to calendar effects (fewer days in February than in, say, January) but sometimes the exchange had to be closed for security reasons. It also suffered from power outages that are typical for Baghdad where it is located.

Figure 3: Number of Trading Sessions per Month at the ISX

24 20 16 12 8 4 0 2004

2005

2006

2007

2008

2009

Source: ISX

Currently, stocks are traded on five days per week, from Sunday to Thursday. Trading hours are from 9:30 to 12:00 am. Initially, trading took place on the floor and stock prices where recorded manually on whiteboards but on April 19th, 2009 electronic trading was introduced. The technology for electronic trading was provided by NASDAQ OMX. When the ISX opened in June 2004, only 15 companies were listed and 6 were traded. As Figure 4 illustrates, the number of listed companies has since increased substantially. In January 2006, the number of listed companies increased to 94 and in November 2008 there was a peak of 96 companies. There was a sudden and drastic drop in the number of listed companies in July 2009 from 91 to 47. Presumably, this is partly related to moving companies from manual trading to electronic trading.

Figure 4: Companies Listed and Traded

100

80

60

40

20 Companies listed Companies traded 0 2004 2005 2006 2007 2008 2009

Source: ISX

Figure 4 also displays the number of companies whose shares were traded in the months from June 2004 to December 2009. A comparison with the number of listed companies shows that many stocks on the ISX are illiquid. In the early years of the exchange, only about half of the stocks listed were actually traded in a month. In more recent times the markets seems to have become somewhat more liquid. In March 2009, 84 per cent of stocks listed were traded. Another key feature of the ISX is the concentration of sectors. The ISX allocates companies into seven sectors but market capitalization is clearly dominated by the banking sector. Figure 5 shows monthly values of market capitalization by sector from the end of 2004 to the end of 2009. There are only three sectors that are identifiable in this graph: Banking, industry and tourism & hotels. The other four sectors of agriculture, insurance, investment and services have typically a market share (in terms of capitalization) that is smaller than 1 per cent. In 2009, even the industry sector declined so much in importance that only two sectors remain to dominate the market. This is certainly surprising. The banking sector is not traditionally a strong sector in Iraq and, given the persistent security problems, Iraq is currently not a very attractive tourist location.

Figure 5: Market Capitalization by Sector

2,800 2,400 2,000 1,600 1,200 800 400 0 2005 2006 2007 2008 Banks Insurance Services 2009

Agriculture Industry Investment Tourism & Hotels

Source: ISX

Another important indicator of market depth is the number of traded shares and trading volume. Time series of both variables are shown in Figure 6. The overall trend is clearly an increase in the number of traded shares and in trading volume, especially after 2006. Most remarkable, however, is the spectacular increase of both variables in July 2007 when more than 72 billion shares were traded and trading volume was about 260 billion dinars. Trading also peaked in June 2008 and May 2009. The incredible volatility in trading confirms the fact that the ISX is still a nascent stock market.

Figure 6: Traded Shares (in million) and Trading Volume (in million ID)
280,000 240,000 200,000 160,000 120,000 80,000 40,000 0 2004 Traded shares Trading volume

2005

2006

2007

2008

2009

Source: ISX

The surge in trading activity in July 2007 is a puzzle. It was the result of trading in the shares of just one bank: North Bank. Total trading volume in July 2007 was 260 billion ID to which the trading of North Bank shares contributed 240 billion. That is more than 92 per cent. North Bank was an extremely dynamic bank. It was founded in January 2004 with a capital of 2.5 billion ID but by December 2006 its capital had increased to 100 billion ID. During July 2007 the share price of North Bank increased from 2.25 ID to 3.90 ID with a peak of 4.75 ID. This price rally had a large impact on the market. In July 2007, the ISX index increased from 25.9 to 40.9. This is an increase of almost 60 per cent! The surge in trading activity in July 2007 is even more surprising given the fact that shortly after, on August 2nd, 2007, the ISX was opened to foreign investors. Perhaps the puzzle can be explained by a kind of front-running activity. Figure 7 shows again the total monthly trading volume but superimposed on the blue shaded area is a red area that represents the trading volume by non-Iraqis. In general foreigners contributed less than 20 per cent to the total trading volume. But there was one significant exception when in April 2009 the trading volume of non-Iraqis (81 billion ID) represented 77 per cent of the total volume. Their trading activity was almost entirely concentrated on the shares of the Bank of Baghdad (Iraq Stock Exchange, 2009, p.4).

Figure 7: Trading Volume (million ID)

280,000 240,000 200,000 160,000 120,000 80,000 40,000 0 2004 Total Trading Volume Trading Volume by Non-Iraqis

2005

2006

2007

2008

2009

Source: ISX

The general conclusion that can be drawn from the analysis in this section is that the ISX is a small, very volatile and rather illiquid market. In such an environment, large orders can move the market substantially. This is not unusual for a nascent market. But often nascent stock markets offer great opportunities to investors. In the next section we examine potential determinants of stock prices in Iraq, as measured by the ISX index.

4 Determinants of the ISX Index

The overall stock price development at the ISX is measured by the ISX index. This index has been criticized for being opaque and dubious (Kubba Consultants, 2007) but it is the only index available. Figure 8 traces the monthly index values from 2005 to 2009. Four points are noteworthy: First, the ISX had its first crash when the index dropped from 72.6 in November 2005 to 25.4 in March 2006. Second, from March 2006 to August 2008 the index was quite static, with the exception of the price surge in July 2007 that was mentioned above. Third, the index was on an apparent bubble path between August 2008 and April 2009 when the index rallied from a value of around 40 to a value of more than 280. Considering that many large international stock markets suffered heavy losses during this period, it is quite miraculous that Iraq was able to escape the global stock-market bust. Fourth, apparently the bubble burst in the summer of 2009. Trading continued but the ISX does not report index values for July and August 2009.

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Figure 8: Development of the ISX Index

300 250 200 150 100 50 0 2005 2006 2007 2008 2009

Source: ISX

The fact that trading of foreigners peaked in April 2009, just before the speculative bubble burst, might raise the suspicion that selling by foreigners led to the crash. Unfortunately, for the months prior to September 2009, published ISX information is only available for trading activity of non-Iraqis in general, without the distinction between buying and selling. However, closer examination shows that it was a transfer between foreigners that explains the large trading volume in April 2009. On April 14th, the Kuwaiti Burgan Bank acquired a 45.3 per cent stake (31.7 billion shares for a price of 80.9 ID billion) in the Bank of Baghdad from the Bahraini United Gulf Bank (AMEinfo, 2009). This transfer constituted 99.9 per cent of the trading volume of foreigners in that month and 76.7 per cent of the total market volume. Moreover, the ISX index continued its surge after April 14th. On that day an index value of 207.6 was recorded but the all-time high was reached one month later on May 14th with a value of 302.1. By all standards, a nearly 50 per cent increase within 30 days is spectacular. It is notoriously difficult to explain the movement of stock prices, especially when they seem to be on a bubble path because then, by definition, they are detached from their fundamental determinants. On the other hand, stock price indices are often modeled as random walks and associated with market efficiency (e.g. Ruppert, 2004). Under both the bubble hypothesis and the random-walk hypothesis it would be futile to try to find fundamental determinants of stock-price developments. We take here an alternative position that has a long tradition in financial research (Chen et al., 1986). We apply a model that identifies macroeconomic factors as determinants of stock prices. In the past, variables such as industrial production, inflation, real interest rates, risk premia or term-structure spreads have been used as determinants. But, because of the special situation of Iraq, we have to be flexible in specifying the model. First, there are serious limitations due to data availability and data reliability. Second, we take the security situation into account because it does not only have an impact on politics but also on the economy. Third, we refrain from isolating unexpected
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components of the variables since the available time series are simply too short for this kind of analysis. The first variable to consider is electricity generated and measured in megawatts (MW). Figure 9 displays the time series from June 2004 to the end of 2009. There is enormous monthly variability but the series is probably too short to identify seasonal factors or to decompose it into trend, cyclical and seasonal component. Visual inspection seems to suggest, however, that there was an increasing trend that started in early 2007. We regard the production of electricity as a good proxy for economic activity because electricity is needed for the production of virtually all goods and services. In Iraq, electricity was also clearly a bottleneck factor for economic activity. According to the Iraq Index of the Brookings Institution (2010), there was no month in 2007 when the average hours of electricity supply per day in Baghdad was more than 9. Advantages of this proxy are that electricity production can be measured precisely and that the variable is available on a monthly basis.

Figure 9: Electricity Generated (MW)

7,000 6,500 6,000 5,500 5,000 4,500 4,000 3,500 3,000 2004

2005

2006

2007

2008

2009

Source: Brookings Institution (2010), p. 30

There are numerous methods and sources available to measure the security situation of Iraq. We decided to use the Iraq Body Count (IBC) data because they are provided by an independent organization and are based on crosschecked media reports as well as hospital, morgue, NGO and official figures. The IBC reports, on a monthly basis, the number of civilian deaths from violence. As Figure 10 shows, the peak of the death toll was reached in 2006. Since then the security situation has improved substantially but by 2009 the monthly death toll was still in the order of 400 or so.

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Figure 10: Civilian Deaths from Violence

3,200 2,800 2,400 2,000 1,600 1,200 800 400 0 2005 2006 2007 2008 2009

Source: Iraq Body Count (2010)

The next step is to enter both the electricity and the death-toll factor into a regression model with the ISX index as the dependent variable. The results are shown in Table 2. The estimated coefficients have the expected signs. An increase of electricity generated by 100 MW would, on average, lead to a rise of the ISX index by 3.4 points and a decrease of the death toll by 100 per month would, on average, lead to a rise of the ISX index by 1.6 points. The estimated coefficients are significantly different from zero at the conventional 5 per cent level. The adjusted R2 shows that the model explains nearly 40 per cent of the variation in the IXS index.

Table 2: Determinants of the ISX Index

Dependent Variable: ISX INDEX Newey-West HAC Standard Errors & Covariance (lag truncation=3) Coefficient C ELECTRICITY DEATH TOLL Adjusted R-squared -67.13381 0.034235 -0.016128 0.392036 Standard Error 51.53663 0.013462 0.006944 t-Statistic -1.302643 2.543105 -2.322573 Probability 0.1981 0.0138 0.0239 0.340746

Durbin-Watson statistic

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However, the Durbin-Watson statistic indicates that there is strong positive first-order autocorrelation of the residuals. Econometrically, the problem of autocorrelation is taken care of by computing heteroskedasticity-and-autocorrelation corrected (HAC) standard errors. But in this particular case, it is instructive to have a look at the pattern of residuals. Figure 11 shows that the residuals were strongly positive from March to June 2009. In fact, the largest value of 183 is obtained for April. Also drawn into Figure 11 are the two solid lines of 44.0 that represent the standard deviation of the residuals (standard error of regression). A roughand-ready 95 per cent confidence interval of the residuals would be the interval 88.0. With this benchmark, the period from April to June can be identified as a bubble with a peak in April.

Figure 11: Residuals of the Regression Equation

200 150 100 50 0 -50 -100 2005 2006 2007 2008 2009

On the other hand, in 2008 the ISX index underperformed with respect to the two fundamental factors. Economic activity, as measured by electricity supply, increased and the security situation improved noticeably but throughout 2008 the ISX index gained little. That is why the residuals of the regression model remained negative through the whole year.

5 Conclusions
The Iraq stock market is a very young and, therefore, quite immature market. Like many other stock markets in this stage of development, it shows high volatility and, in general, a lack of liquidity. Every month, there is quite a gap between the number of stocks listed and the

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number of stocks traded. Even as recent as December 2009, only 73 per cent of the stocks listed were also traded. Despite its short history, the ISX has already witnessed one apparent bubble period and two crashes. The Iraq stock market would certainly benefit greatly from further improvements in the security situation in the country both directly and indirectly. Our regression analysis has quantified the gains to be realized if and when civilian deaths from violence can be reduced. The indirect effect would work via increased economic activity. Economic growth would certainly pick up once political instability and terrorist attacks are overcome. Some progress has certainly been made in macroeconomic performance. Real growth has increased and inflation has come down but there is room for further improvement. Our analysis of the Iraq stock market is restricted by data issues. First and foremost, data reliability is still questionable. There are several inconsistencies in published data and sometimes it is difficult to square the development of the ISX index with that of its sub-sector indices or with that of individual shares. For more sophisticated analysis, like co-integration analysis, the time-series are still too short. In addition, the availability of daily ISX index data would make it possible to conduct more in-depth time-series analysis. Therefore, we hope that the future will bring both an improvement in the market and in our analysis of it.

References
Al-Salam, Taha Ahmed (2009), Iraq Stock Exchange Presentation; http://www.isx-iq.net/isxportal/portal/chiefExecutive.html AMEinfo (2009), Burgan Bank completes transfer of Bank of Baghdad and Algeria Gulf Bank, http://www.ameinfo.com/195362.html Brookings Institution (2010), Iraq Index: Tracking Variables of Reconstruction & Security in Post-Saddam Iraq, 27th April 2010; http://www.brookings.edu/~/media/Files/Centers/Saban/Iraq%20Index/index.pdf Chen, N.-F., R. Roll and S.A. Ross (1986), Economic Forces and the Stock Market, Journal of Business, 59 (3), 383-403 Iraq Body Count (2010), Documented Civilian Deaths from Violence; http://www.iraqbodycount.org/database/ Iraq Stock Exchange (2007), Monthly Bulletin, July 2007 Iraq Stock Exchange (2009), Monthly Bulletin, April 2009 Kubba Consultants (2007), Dubious ISX index; http://www.isx-aman.com/news/rep_index_2007_03_28.htm Ruppert, D. (2004), Statistics and Finance, Springer

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